The proposal will have little effect on the economy but could cause more harm than good
Tonight, President Obama will speak to the nation about ways in which he believes Washington can inject some adrenaline into the languishing economic recovery. It isn't hard to figure out why: job growth has been trending down and may have ceased altogether in August. With unemployment still near double digits, that's a big problem.
Some reports indicate that he'll announce one stimulus measure that purports to cost taxpayers nothing. The administration may push Fannie and Freddie to allow more homeowners to refinance at current very low mortgage interest rates. The measure might sound good in theory but will ultimately amount to another failed attempt at healing the housing market and broader economy.
Inside Mortgage Finance reports that the president could announce what it calls a re-worked "Home Affordable Refinance Program" ("HARP 2.0"). The idea is simple enough: push the agencies to allow more borrowers to refinance at very low interest rates, around 4%. For borrowers with mortgage rates at or above 6%, this savings becomes real money that can be spent to stimulate the economy.
How much money are we talking about homeowners saving? It depends on their previous interest rate and mortgage size. For a family that originally had a $250,000 mortgage at 6%, moving to a 4% interest rate would cut their monthly payment by at least $300. If their mortgage payment was initially 35% of their income, then this is like giving their income a 7% boost.
The administration might like this plan for two reasons. First, it wouldn't take any legislation if the Federal Housing Finance Authority coerces Fannie Mae and Freddie Mac to go along. Second, it wouldn't directly cost taxpayers anything or increase the size of the deficit.
There Is a Cost
But generally, whenever someone is gaining money, someone else is losing that money. This proposal is no exception to that rule. The losers here would be mortgage bond investors and taxpayers.
Loss to Investors
When you purchase a mortgage-backed security, you've got to worry about two sorts of risk: default risk and prepayment risk. That first sort is straightforward enough: if homeowners stop paying their mortgage, then you may incur a loss related to that default.
The second, however, is a little more subtle. The interest and principal payments made by borrowers eventually make their way to investors through bond interest and principal payments. But if borrowers pay back their loan quicker than anticipated, then the mortgage bond is paid off sooner. As a result, the investor's bond doesn't provide as much interest as it was expected to pay over a given time period.
In the case of MBS issued by Fannie and Freddie, investors only have to worry about prepayment risk: the government covers any losses due to defaults. But they can't escape prepayment risk. As more borrowers refinance, prepayment risk grows. As a result, if the government encourages more refinancing, then these agency MBS would lose value.
Loss to Taxpayers
Of course, taxpayers would face a similar loss: any mortgages still held in Fannie's or Freddie's portfolios that are refinanced would be paid off early. That loss might not show up as a direct cost, since it consists of interest that will never be paid. But this additional interest would have offset some of Fannie and Freddie's losses over time, for which taxpayers are on the hook.
Taxpayers could lose in another way. Presumably, most borrowers that wanted to refinance and could qualify have done so. Those who would like to refinance but haven't can't qualify. That's because either they aren't a prime borrower and/or their mortgage is underwater.